BOE Quick Analysis: The R-word bursts out, and the pound plunge is far from over

A UK recession is coming – the cat is out of the sack, and sterling bulls have turned into mice searching for shelter. There is room for more, as the volatile currency pair digests the decision and the monetary policy divergence with the Fed.  And I would add that It could also drag the euro down. 

The massive increase in energy prices is set to push inflation to 10% – something which should have pushed the pound higher. If price rises are rapid, so are interest rates.  Indeed, no fewer than three out of nine members of the Bank of England's committee voted for a 50 bps hike. That is more than the markets expected.

However, there is too much of a "good" thing, and that hits the pound hard. The BOE's Monetary Policy Report (MPR) includes big headlines not only double-digit inflation but an outright recession. By the fourth quarter, the surge in prices is set to erode Brits' disposable income enough to trigger a contraction, which could extend to another quarter. The rest of the report also consists of dire warnings. 

Is the gloom already priced into GBP/USD? Probably not. First, this currency pair is extremely volatile, and after a period of tension, it could extend its falls. 

Secondly, Governor Andrew Bailey and his colleagues are likely to continue warning the public of the dangers of inflation. They already did it before their recent "blackout period" and now they have free reign to repeat it. BOE members are aware of the public's inflation angst, and will likely relate to that. They would be taking a page from Fed Chair Jerome Powell, who began by addressing the American people. More gloom means a weaker pound.

Third, markets have yet to digest two critical rate decisions in the space of less than 24 hours. The Federal Reserve remains content with the US economy and seems confident of orchestrating a "softish landing." The BOE minces no words.

Monetary policy divergence is the fuel of forex action – and I see further GBP/USD downside. 

The gloom from the BOE may also impact the euro. Both the eurozone and the UK are suffering from Russia's invasion of Ukraine. Moreover, inflation in Britain is more broad-based than in the eurozone, where the Great Resignation seems to be an Anglo-Saxon phenomenon.

Without higher wages, inflation is set to remain stuck in the eurozone. So, if a recession is coming to the UK, it is hard to see the eurozone evading one, and the ECB meaningfully raising rates.